A Theory of Credit Scoring and Competitive Pricing of Default Risk

We propose a theory of unsecured consumer credit where: (i) borrowers have the legal option to default; (ii) defaulters are not exogenously excluded from future borrowing; (iii) there is free entry of lenders; and (iv) lenders cannot collude to punish defaulters. In our framework, limited credit or credit at higher interest rates following default arises from the lender’s optimal response to limited information about the agent’s type and earnings realizations. The lender learns from an individual’s borrowing and repayment behavior about his type and encapsulates his reputation for not defaulting in a credit score. We take the theory to data choosing the parameters of the model to match key data moments such as the overall and subprime delinquency rates. We test the theory by showing that our underlying framework is broadly consistent with the way credit scores affect unsecured consumer credit market behavior. The framework can be used to shed light on household consumption smoothing with respect to transitory income shocks and to examine the welfare consequences of legal restrictions on the length of time adverse events can remain on one’s credit record.